Using Stocks to Hedge Against Inflation

As our economy and stock market tanked over the last several months, talk of inflation seemed to disappear. Instead, people began discussing the possibility (and ramifications) of deflation. Now that the stock market has picked back up–at least for the moment–I’ve heard several people voice concerns about inflation again.

Over an investor’s lifetime, inflation takes a giant bite out of investment returns. For example, if an investor owns a portfolio of bonds on which he earns a 6% rate of return, he’s probably only increasing his purchasing power at a rate of roughly 3% per year. In other words, inflation can easily eat up more than half of the return provided by fixed income investments.

Owning Tangible Assets

Investment “experts” often suggest owning gold or other commodities as a hedge against inflation. The idea is that tangible assets should be able to hold their value even in an economy in which the primary currency is losing its own value.

This makes sense to me. And historically, it’s worked fairly well. However, I don’t personally own any gold or other commodities in my portfolio.

Why? Because stocks are real assets too.

Many people seem to think of stocks (or mutual funds made up of stocks) as simply numbers in an account. And, given the everything-happens-online nature of the investment world we live in, it’s easy to forget that a stock represents a piece of ownership in a very real asset–a business.

Stocks Over the Short-Term

An astute reader might point out that stocks prices don’t typically increase when inflation levels increase. That’s true. And as a result, stocks aren’t very good at protecting against short-term inflation.

I’d argue, however, that inflation over short periods tends to be fairly inconsequential. Most people aren’t even going to notice if their portfolios decrease in value by 1-2% due to inflation. It’s generally only over extended periods that inflation becomes a big threat.

Stock Over the Long-Term

Thankfully, over long periods, stocks do quite well at holding their value in the face of inflation. Why? Because again, stocks represent businesses. And what do businesses do during inflation? They just raise their prices.

Note the contrast between this and the situation in which workers find themselves. As an employee, it’s hard to simply “raise your price.” Comparatively speaking, businesses are well-suited to dealing with rising price levels.

In summary…

If for some reason you’re worried about a huge jump in prices during the next few months, putting (or keeping) your money in stocks might not be the way to go.

If, however, you’re simply looking to protect yourself from the long-term effects of inflation, a diversified portfolio of stocks should get the job done quite nicely.

Mike writes at The Oblivious Investor, where he reminds readers to ignore the day-to-day craziness in the market and focus instead on getting the investing basics right. Subscribe to his blog for daily updates.

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Very interesting advice. I might add that people should invest in mutual funds to let someone else diversify their portfolio for them. Otherwise, most people will constantly watch their stocks and potentially pull their money when the market goes down. Ultimately, stocks as a long-term investment are a good idea in my opinion (just make sure you never count on the money being there – I’m sure some people did 10 years ago and are regretting it).

You’re absolutely right. I’m a big fan of mutual funds as a method of achieving diversification. (In fact, I almost take it as a given. When I say “stocks” I generally mean “mutual funds consisting of stocks.”)

During the inflation of the 70’s stocks did very poorly. High interest rates drove down the stock market as people went to other investments that gave them a high interest rate return. Also inflation eats away at corporate profits and its tough for a company to keep up. Also high interest rates, which accompany times of high inflation, makes the cost of borrowing for companies that much more.

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